06 September 2012

Cash-futures arbitrage derisks trading ::Business Line

The BSE recently introduced a Cash-Futures Spread (CFS) facility in the derivatives segment. This facility is offered on all underlying stocks on which derivative instruments are available for trading in the BSE derivatives segment.

ARBITRAGE ADVANTAGE

Previously, investors who wanted to take advantage of the spread between futures and cash had to make four trades, i.e. buy (sell) in futures and sell (buy) in cash and then reverse the trade to square off the position. For example, let’s assume a stock is trading for Rs 100 and the next-month futures are trading for Rs 101, with an interest rate of 0.5 per cent per month. Ideally, the futures contract should have been trading at Rs 100.50, assuming that market conditions remain the same.

To take advantage of this anomaly, the investor will short the futures and go long in the cash market. As the expiry date draws closer, the futures price will converge to the fair value and the investor will cover his position by reversing the trade, i.e. going long on the future and short on the stock. As the futures price moves below Rs 101, the investor will be able to earn a neat risk-free profit.

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RISK MITIGATION

But there is an execution risk. What if prices rise abruptly in the third leg of the trade, i.e. going long on the future, which could result in losses for the investor? The BSE’s Cash-Futures Spread facility is certainly helpful in mitigating this risk. Buying a CFS will create a short position in the equity segment and long position in the futures segment. Selling a CFS will result in the opposite position.

The CFS will be available for trading across three contract months, viz. current, near and far monthly futures instruments. A simple illustration can help us understand the CFS facility better. Suppose we place a buy order for a stock at Rs 100 in the CFS facility. This trade will be split into two trades, namely a short position on the stock at Rs 100 and long position in the stock at Rs 100+ Rs 1= Rs 101, where Rs 1 is the extra amount or premium the seller is expecting and can vary according to market conditions. CFS will certainly help the BSE increase its volumes. However, whether it will benefit individual traders is a moot point as it will be tough to sniff arbitrage opportunities manually, considering increasing participation from algorithmic traders.